The crisis has revealed the vulnerabilities of the Eurozone financial sector and the critical role the sector plays in the real economy. It also made it clear that the Eurozone banking system needs fixing. But what reforms should we implement? It is critical that much better legislation be both discussed and implemented if we wish to properly regulate the financial sector. This column opens a Vox debate on banking reform whose aim is to stimulate an open and broad-ranging discussion on banking reform.

Better regulation is important for reducing the chances of another major financial crisis, but better regulation may also be an essential factor in re-establishing confidence in the financial sector itself. Indeed, it is thought that such confidence may be an essential ingredient for a healthy economic recovery.

We knew about systemic risk before the crisis

Even before the crisis, it was well known that our financial system was exposed to some key risks. Generations of students have been taught that financial institutions financing long-term investments with short-term liabilities may face bank runs (Stern and Feldman 2004). Pre-crisis, it was also well understood that governments have an incentive to bail out large financial institutions. The implications of a bank going bust for the rest of the financial system and the economy could be dire, so perverse incentives for ‘too big to fail’ institutions to take on too much risk remained (Daníelsson et al. 2001). It was even recognised that risk is endogenous, and that Basel II had the potential to exacerbate this problem (ibid.). For example, in response to an aggregate drop in asset prices, banks may want to – or, because of legislation, have to – sell assets, which in turn leads to a further drop in asset prices and an increase in the chance of default1.

Underestimated levels of risk and insufficient legislation

Despite this wisdom, the risks were clearly underestimated and the mechanisms to prevent severe disruptions were clearly not in place. Now we are designing new legislation, it is important that we understand what went wrong.

During the postwar period, there had been numerous innovations in the financial sector and there were plausible reasons to believe that these innovations would stabilise the system. For example, the ‘originate to distribute’ system and new derivatives, like mortgage-backed securities and credit default swaps, would make it possible to spread risk over a wider group of investors. The empirical facts seemed to support this. Since the mid-1980s, the economy displayed robust growth with only minor economic downturns. The financial system was able to stomach potentially cataclysmic events such as the collapse of the dotcom boom and the Enron downfall. Perhaps it is simply human nature to become more confident when things are going well. Whatever the case, we were overconfident and acted accordingly. Importantly, the Depression-era Glass-Steagall Act was repealed in 1999, ending separation in the US between commercial banking and investment banking. Mortgages were often no longer held by those that had originated the loan. Securities rapidly became much more complex2. Rating agencies and financial regulators did not have the resources and expertise to deal with this increased complexity. Perhaps the main indicator of this overconfidence is that salaries in the financial sector increased by much more than in other sectors (Philippon and Reshef 2008).

Regulate for an ever-changing world

The new set of rules should not only fix known problems. The world is likely to change, new vulnerabilities are likely to appear, and financial institutions may very well try to find ways around legislation. So the new regulatory system should be flexible enough to deal with a changing world and it also should be such that complacency cannot put our economy at risk again. Writing for VoxEU.org, Aizenman and Noy (2012) show that being exposed to a financial crisis does not reduce a country's probability of being hit by another financial crisis. They suggest that this may be due to the inability of regulators to keep up with the dynamic evolution of modern banking. It is evident that more than mere additional legislation is needed.

Clearly, we need better funded oversight and better in-depth knowledge among financial regulators and academics about what is actually going on in the financial sector. The likelihood is that reducing risk will also require a change of culture in the financial sector itself. The decisions made by individuals working in financial institutions ought to be in line with the long-run growth and stability of both the overall institution and the overall economy, not any one individual’s short-term prospects.

Recent legislation

There have been a lot of proposals for new legislation. Some have already been implemented:

In November 2010, Basel III was endorsed by G20 leaders at the Seoul summit, and there will be a phased implementation with full application in 20193.

In July 2010, The Dodd-Frank Wall Street Reform and the Consumer Protection Act were signed into law (cf. Kane 2012).

In June 2012, the UK Government published a white paper describing the current coalition’s legislative reactions to the recommendations of the Vickers report (HM Treasury 2012).

In October 2012, the Liikanen group published the Report of the European Commission's High-level Expert Group on Bank Structural Reform.

On 18 November this year, the Financial Stability Board (FSB) published proposals for oversight and regulation of shadow banks (Financial Stability Board 2012).

Questions

Has enough been done to reduce the chance of another financial crisis?

Are governments overreaching and is the new regulation going to stifle growth in the financial sector? And would that matter?

Will the higher capital adequacy requirements of Basel III make the system sufficiently safe? And will they make lending (much) more expensive?

Will the countercyclical buffers of Basel III be enough to avoid systemic downward spirals?

Are the new liquidity requirements going to avoid contagion in the interbank market?

What kind of institutional change in the markets for derivative trading will take care of counter-party risk? How can we tackle the possibility of institutions falling like dominos, and by doing so solve the ‘too connected to fail’ problem?

What kind of division should there be between traditional commercial banking and other activities? Is it enough to implement the Volcker rule that limits proprietary trading, that is, trading of financial assets with the institutions own money?5 Or should there be a stricter separation between commercial and investment banking activities as proposed by the Liikanen and the Vickers report?

Can or should regulation be (somewhat) different across countries? And will countries with stricter regulation face capital flight?

This debate is all about these questions and we encourage you to respond to them or to highlight other questions. If you want to contribute to this debate, please write a column -- or respond to a column -- and email me your submission at [email protected].

References

Aizenman, Joshua, and Ilan Noy (2012), “Macroeconomic adjustment and the history of crises in open economies”, VoxEU.org, 21 November.

1 When teaching MBA students, I used to illustrate this possibility of downward spirals with the wobbling of the Millenium bridge. See http://www.youtube.com/watch?v=gQK21572oSU. The nice thing about the video is that it makes clear that the crisis occurs because "... people changed the way they walked in reaction to the movement of the bridge ... more importantly, the people’s reaction was almost identical, everyone stepped the same way at the same time creating a synchronized rather than a random force". That is systemic risk!

2 Michael Lewis' book The Big Short provides a telling insight into the lives of the people who did have the stamina to read the terribly long prospectuses of mortgage-backed securities.